Equity Markets To Drop In The Fall

 |  Includes: IVV, SDS, SH, SPY, SSO, VOO
by: Mary Gates


Equity volatility will rise as risk premia increase due to reduced Federal Reserve liquidity support. Lack of balance sheet expansion should limit future gains in equity indices.

As Quantitative Easing (QE) concludes in October, look for developed market equity indices to drop roughly 10% to 15%. This would bring equities closer to historical average PE ratios.

Traders or investors looking to hedge their portfolios or profit from a drop in equity prices should buy put options on the SPDR S&P 500 ETF.

Global equity markets have surged higher over the past several years due to unprecedented central bank liquidity injections. The seemingly inexorable rise in equities has created an eerie complacency often witnessed before stock market corrections. I believe the current conditions and impending developments will lead to a 10% to 15% correction in equity markets during the months immediately following the end of QE.

The Fed intends to end their QE program in October 2014, which means balance sheet expansion will end. It is unclear whether they will reinvest proceeds such as interest payments and bond maturities from assets currently held on the Fed's balance sheet. If they were to reinvest proceeds, that would only keep the balance sheet from contracting. As seen in the following chart, equity markets have been closely correlated with the size of the Fed's balance sheet since the QE program's inception in late 2008.

Without further balance sheet expansion, market volatility is likely to rise, increasing equity risk premia and contracting price to earnings multiples. Investors should beware that rising market risk premia and falling PE's can occur without any increase in interest rates. Most traditional valuation metrics such as price to earnings and Shiller ratios are near their upper boundaries, making mean reverting strategies attractive. For example, the S&P is currently valued with a price to earnings multiple approaching 20 and the historical average tends to be closer to 15 or 16. I believe once the Fed eliminates QE, equity volatility will rise, which will increase risk premia and place downward pressure on equity multiples. Under my scenario, the S&P 500 falls from 2000 today, down to somewhere between 1700 or 1775, which would bring the PE ratio down to 16 or 17.

QE created a virtuous cycle that filtered into the equity markets and helped expand price to earnings ratios through several channels: (1) it reduced asset market volatility, (2) it lowered interest rates and (3) low interest rates facilitated a corporate buyback mechanism that put an underlying bid under equity prices, which made investors more confident that earnings per share would rise. As investors become more confident in the growth of a company's earnings per share, they tend to value the company's stock at a higher price to earnings multiple.

First, the piles of money pumped into the financial system worked to suppress asset volatility in practically every financial market asset from currencies, credit spreads, interest rates, to equities. The reduced market volatility from QE's liquidity injections effectively reduced equity risk premia and expanded price to earnings multiples for equities as markets were perceived as less risky.

Second, the Fed's program suppressed interest rates, which are an important input in discounting a company's future cash flows and hence, arriving at a company's market valuation. Lower interest rates increase the present value of the company's future cash flows and support higher market valuations. Interest rates are at historically low levels and unlikely to fall much further for a sustained period of time. Therefore, we aren't likely to see another push higher in equity valuations coming from lower interest rates. In the future, interest rates are likely to rise, which will become a headwind rather than a tailwind for equity valuations. However, even if interest rates do not rise, the marginal impact on equity valuations from a further decline in interest rates would likely be limited given current low level of rates.

Third, low interest rates have encouraged corporations to become more leveraged. Instead of keeping cash on balance sheets earning a meager return, firms deployed excess cash into buying back company stock. In addition, some firms such as Apple (NASDAQ:AAPL) even increased bond issuance in order to buy back stock and pay higher dividends to shareholders. It is interesting to note that as equity prices have soared, more firms have recently reduced stock buybacks, perhaps in anticipation of a decline in share prices. As firms scale back purchases of company stock, that's another factor that will provide a lower level of valuation support in the coming quarters.

Once the Fed ends QE in October, there will likely need to be a significant slowdown in the economy in order for the Fed to reinstate QE. The bar for additional QE will likely be much higher as the Fed's forecasting credibility would be in question if they reinstated QE only a few months after terminating the program. Additionally, investors would have confirmation of the suspected Fed put option, meaning the Fed will stimulate markets at the slightest whiff of recession or market correction. Indeed, that is why the Fed has been reluctant to end QE; once out, it is a high hurdle to get back in. That suggests there will be less Fed support in the months following QE and I don't think the market is presently pricing that risk accurately.

For example, suppose the Fed ends QE and two months later the economy appears to be trending lower and equity markets correct maybe 5%. If the Fed gets nervous and announces QE again, the market will become euphoric and equities will become a guaranteed bubble, as investors would have confirmation that the Fed put is basically at the money. Investors would almost certainly dial up risk to the max in anticipation of the Fed stepping in at the slightest downtick in the economy. This would clearly be an unsustainable and disastrous path for the Fed to travel down. The idea that investors perceive a Fed put option leads investors to take greater levels of risk over time. Therefore, I think the Fed understands this and is highly unlikely to reinstate QE once the program concludes.

As the Fed watches from the sidelines, financial markets could become turbulent; volatility should rise as the market perceives a lower level of Fed support. In general, investors are underestimating risk across asset classes and they are not being paid commensurately for risks taken. All of this against a backdrop of slower growth trends seen in many countries throughout the developed and developing world. If countries such as Europe, Japan, China, Russia and Brazil continue to see growth decelerate, U.S. equity markets will become much more challenged when QE ends.

Therefore, it seems like a wise trade or portfolio hedge to begin buying SPDR S&P 500 ETF (NYSEARCA:SPY) put options in anticipation of a correction in the months following the end of QE. Put options limit your hedge or trading losses if the equity markets continue to rise. Put options are an attractive idea as they would gain from an increase in equity market volatility, but the drawback is you must be correct in timing the trade when using options. In addition, if you are an investor with a long position in the ETF, you may want to consider selling covered calls around the time QE ends and use the premium to cheapen the purchase of put options.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.